Relevant cost of material is the future incremental cashflows of new raw material to be purchased and/or opportunity cost of the existing material that can be used.
For instance, a business received a customer order for which cost is to be ascertained. The raw material needs to be purchased for this order, the business will pay the supplier for the purchase of raw material and that cost becomes the relevant cost of the material.
But things become complex when we have existing spare material in stock and we plan to use this in the customer order. The question is how can we charge the material cost for the customer order? We have bought materials a few months ago, we know that past cost is sunk cost, so we cannot take that cost as a relevant cost.
Before a detailed comprehension, first see the following flow chart for the relevant cost. Then we’ll explain it with examples.
Explanation – Relevant cost of materials
Suppose a customer order to produce 100 units of Product A is in place. We need to estimate the cost of this order so that we can decide whether we should accept this order or not, based on the profitability. The first cost that we need to add to our calculation is the materials cost. It requires 500 kg of material M to produce 100 units of product A.
The first thing we need to ask is, do we have material M in stock? If the answer is No, then we need to buy 500 kg from the market and the current market price or purchase cost of 500 kg will be the relevant cost. Let’s say the market price per kg of Material M is $5. The total relevant cost of material, in this case, would be $2,500.
Let’s suppose we have 1,000 kg of material M in stock. The next thing we need to know is, whether this material is in regular use or not. Regular use means that we are using this material regularly in the company’s main product. So, if the material is in regular use and we use that material in the special customer order, we must buy that quantity of material from the market which we have used in the order. The relevant cost of material would be the current market price which is $2,500.
Let’s say 1,000 kg of material M is in stock and this material is not in regular use. For example, we purchased this material for a customer order 2 months ago. As a result of overbuying, 1,000 kg was left in stock, and it is not being used in any of the main products by the company. We can use this material in the order. What shall be the relevant cost to be charged? Let’s say we have two options:
- either we can sell in the market at $2 per kg (total of $1,000 for 500 kg needed), or
- we can use this in another customer order which can save our cost to $2.5 per kg (total $1,250 for 500 kg needed.
Considering both options, we conclude that the maximum benefit we can get from 500 kg in stock is $1,250. If we use this 500 kg in this customer order, we are going to lose $1,250 which is the opportunity cost. So, the relevant cost of the material would be $1,250.
For further understanding, let’s see the following illustration.